Howard Marks, Oaktree Capital — 2023-04-17
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Memos from Howard Marks 2023-04-17T07:00:00.0000000Z" pubdate title="Time posted: >4/17/2023 7:00:00 AM (UTC)">Apr 17, 2023
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This isn't going to be another history of the meltdown of Silicon Valley Bank. Dozens of those have appeared in my inbox over the past month, as I'm sure they have in yours. Thus, rather than merely recount the developments, I'm going to discuss their significance.
My sense is that the significance of the failure of SVB (and Signature Bank) is less that it portends additional bank failures and more that it may amplify preexisting wariness among investors and lenders, leading to further credit tightening and additional pain across a range of industries and sectors.
One-off or a Harbinger of Things to Come?
A number of things about SVB made it somewhat of a special case – which means it probably won't turn out to be the first of many:
The bank's business was heavily concentrated in a single sector – venture capital-backed startups in tech and healthcare – and a single region – Northern California. Many regional banks' businesses are similarly concentrated, but not usually in sectors and regions that are both highly volatile.
The boom in its sector and region caused SVB's business to grow very rapidly.
In recent years, startups were a major destination for investors' cash, a good deal of which they deposited at SVB. This caused SVB's deposits to triple, from $62 billion at the end of 2019 to $189 billion at the end of 2021.
For the same reason, many of SVB's clients had so much capital that they had little need to borrow. As deposits piled up at SVB, there wasn't offsetting demand for loans. Few other banks have customers with similar cash inflows and consequently so little need to borrow money.
Because SVB had few traditional banking uses for the cash that piled up, it instead invested $91 billion in Treasury bonds and U.S. government agency mortgage-backed securities between 2020 and 2021. This brought SVB's investments to roughly half its total assets. (At the average bank, that figure is about one-quarter.)
Presumably to maximize yield – and thus the bank's earnings – in what was a low-return environment, SVB bought securities with long-dated maturities. SVB designated these securities as "hold to maturity" (HTM) assets, meaning they wouldn't be marked to market on the bank's balance sheet since it had no intention of selling them.
When the Federal Reserve embarked on its program of interest rate increases last year, bond prices fell rapidly, and, of course, the longer the tenor of the bonds, the greater the decline in value. In short order, the market value of SVB's bond holdings was down $21 billion.
Word of the bank's losses caused depositors to start withdrawing their money. To meet the withdrawals, SVB had to sell bonds. Consequently, the bonds could no longer be considered HTM. Instead, they had to be categorized as "available for sale" (AFS), meaning (a) the bonds were marked down on SVB's financial statements and (b) actual sales caused the losses to be crystalized.
The recognized losses helped hasten the spread of negative rumors throughout the tight-knit venture capital community, which led to further withdrawals. An unusually large percentage of SVB's deposits – 94% – exceeded $250,000 and thus weren't fully insured by the FDIC. This meant they were more "institutional" than "retail." Additionally, SVB's customers were highly interconnected: They had many backers in common, lived and worked near each other, and could exchange information almost instantaneously through social media.
The sum of the above rendered SVB particularly vulnerable to a bank run if adverse circumstances developed – and they did. However, many of the above factors were peculiar to SVB. Thus, I don't think SVB's failure suggests problems are widespread in the U.S. banking system.
What Did SVB Have in Common with Other Banks?
I talked above about some things that distinguished SVB from other banks. But it's as important to consider the elements they shared:
This mismatch, like most other mismatches, is encouraged by the upward slope of the typical yield curve. If you want to borrow, you'll find the lowest interest rates at the "short end" of the curve. Thus, you minimize your costs by borrowing for a day or a month . . . but you expose yourself to the risk of rising interest expense, since you haven't fixed your rate for long. Similarly, if you want to lend (or invest in bonds), you maximize your interest income by lending long . . . but that subjects you to the risk of capital losses if interest rates rise . If you follow the yield curve's dictates, you'll always borrow short and lend long, exposing you to the possibility of an SVB-type mismatch.
High leverage – Banks operate with skinny returns on assets. They pay depositors (or the Fed) a low rate of interest to borrow the funds they need to operate, and they lend or invest those funds at slightly higher rates, earning a modest spread. But they literally make it up on volume. They employ heavy leverage, meaning they can do a lot of business based on little equity capital, thereby translating a low return on assets into a high return on equity. However, having a high ratio of total assets to equity capital means a modest decline in asset prices can wipe out a bank's equity, rendering it insolvent. There's no source of meltdown – in any sector – as potentially toxic as the combination of high leverage and an asset/liability mismatch. Banks have them both.
Reliance on trust – Since depositors put money in banks in pursuit of safety and liquidity and, in exchange, accept a low return, faith in banks' ability to meet withdrawals is obviously paramount. Depositors ostensibly can get liquidity, safekeeping, and low interest from any bank – that is, one bank's offering is essentially undifferentiated from those of others. Thus, most depositors are perfectly willing to change banks if given the slightest reason, and there's no offsetting reason for them to leave their money on deposit if a bank's safety is questioned.
You may be familiar with one of my favorite sayings: "Never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average." Surviving on average is a useless c